TECHNIQUES FOR
TREATING RISKS
Steps in risk management process
1. Identify potential losses
2. Evaluate potential losses
3. Select the appropriate techniques for treating loss exposure
4. Implement and administer the program
Potential losses
1.
Property loss exposure
Building, plants, furniture, equipment, supplies, computer software, inventory,
account receivable, mobile equipment
2.
Liability loss exposures
Environmental pollution, discrimination against employees, misuse of internet &
email transmissions
3.
Business income loss exposure
Loss of income from a covered loss, continuing expenses after a loss, extra
expenses
4. Human resources loss exposure
Death or disability of key employees, retirement or unemployment, injuries
Potential losses
5. Crime loss exposure
Robberies, burglaries, employee theft & dishonesty, internet & computer crime
6. Employee benefit loss exposure
Failure to comply with government regulations, failure to pay promised benefits
7. Foreign loss exposure
Plants, business property, inventory, foreign currency risks, kidnapping of key
personnel
Sources of information
1. Risk analysis questionnaires
2. Physical inspection
3. Flowcharts (flows of production & delivery, to reveal
bottlenecks where a loss can have severe financial
consequences for the firm)
4. Financial statements (to identify the major assets that must
be protected)
5. Historical loss data
Evaluating potential losses
• = evaluate and measure the impact of losses on the firm
• This involve:
1. Loss frequency
 The probable number of losses that may occur during some
given time period
2. Loss severity
 The probable size of the losses that may occur
• Once the risk manager estimate the frequency and severity of
loss for each type of loss exposure, the exposure can be ranked
according to their importance.
• Catastrophic losses are difficult to predict because they occur
infrequently  their potential impact on firms must be given
high priority
Techniques to treat loss exposures (1)
A. Risk control
Reduce the frequency and severity of accidental losses:
1. Avoidance  an existing loss exposure is abandoned
Example: Build a new plant not in a flood plain, withdraw
dangerous drugs from market, etc.
Advantage: the chance of loss is reduced to zero
Disadvantage:
 the firm may not be able to avoid all losses,
 it may not be feasible or practical to avoid the exposure
An organization can avoid risk by:
 Eliminating the source of the risk
 Eliminating the exposure of assets to the risk
Techniques to treat loss exposures (1)
2. Loss control:
a) Loss prevention  reduce the frequency of loss
Example: reduce truck accident: driver examination, zero
tolerance for alcohol, strict enforcement of safety rules
b) Loss reduction  reduce the severity of loss after it occurs
Example: installation of rehabilitation of workers with jobrelated injuries, having warehouses with inventories at
different locations
Techniques to treat loss exposures (2)
B. Risk financing
Provide for the funding of accidental losses after they control
1. Retention
The firm retains part of all of the losses that can result from
a given loss
 active retention  the firm is aware of the loss exposure &
plans to retain part or all of it
 Passive retention  tend to be failure to identify a loss
exposure, failure to act, or forgetting to act
Techniques to treat loss exposures (2)
2. Noninsurance transfers
Methods other than insurance by which a risk and its
potential financial consequences are transferred to another
party.
It includes contract, leases, hold-harmless agreements
3. Commercial insurance
Appropriate for loss exposure that have a low probability of
loss, but a high severity of loss
Retention (1)
• This method of treating loss is effective when:
1. No other method of treatment is available
 Insurers may be unwilling to write a certain type of
coverage (too expensive)
 If exposure cannot be insured or transferred, it must be
retained (all losses cannot be eliminated)
2. The worst possible loss is not serious
 Physical damage losses to automobiles in a large firms will
not bankrupt the firm if those cars are not simultaneously
damaged
3. Losses are highly predictable
 Effective for workers compensation claims, physical damage
losses to automobiles, shoplifting losses
•
Retention (2)
• If retention is used, risk manager must determine the retention
level (a dollar amount of losses that the firm will retain)
• Financially strong firm can have a higher retention level.
• Methods to determine retention level:
1. Determine the maximum uninsured loss it can absorb
without adversely affecting the firm’s earnings
Max retention: 5% of the firm’s annual earnings before taxes
2. Determine the maximum retention as a percentage of the
firm’s net working capital
Max: 1-5%
Retention (3)
• How to pay losses
1. Using current net income (treat losses as expenses)
2. Unfunded reserve (to book actual or expected losses)
3. Funded reserve (setting liquid funds aside to pay losses)
4. Credit line (borrow funds from a bank)
5. Captive insurer (an insurer owned & established by a parent
firm for insuring the parent’s loss exposure)
Self insurance
 One of risk management programs
 It is technically not insurance, a pure risk is not transferred to
an insurer
 A special form of planned retention by which part or all of a
given loss exposure is retained by the firm
 = self funding  losses are funded & paid by the firm
 For workers compensation insurance, provide group dental,
vision, & prescription drug benefits to employees
Advantage & disadvantage of retention
• Advantages
1. Save money (long-term, if actual losses are less than the ones
insured)
2. Lower expenses (some expenses may be reduced: loss-adjustment
expenses, general administrative expenses, insurer’s profits, etc.)
3. Encourage loss prevention (greater incentives for loss prevention)
4. Increase cash flow (firms can use the funds normally be paid to
insurer)
• Disadvantages
1. Possible higher losses (loss retained may be greater than loss
allowance in the insurance premium that is saved by not
purchasing the insurance)
2. Possible higher expenses (expenses to hire outside experts may be
higher)
3. Possible higher taxes (income taxes may be higher, as premium
paid to insurers are income-tax deductible)
Advantage & disadvantage of noninsurance transfer
• Advantages
1. Risk managers can transfer potential losses that are not
commercially insurable
2. Noninsurance transfers often cost less than insurance
3. The potential loss may be shifted to someone who is in a
better position to exercise loss control
• Disadvantages
1. Transfer of potential loss may fail because the contract
language is ambiguous. No court precedents for the
interpretation of contracts
2. If the party to whom the potential loss is transferred is unable
to pay the loss, the firm is still responsible for the claim
3. Noninsurance transfer may not always reduce insurance costs,
because an insurer may not give credit for the transfer
Insurance (1)
• If the risk managers use insurance, they must consider 5 keys:
1. Selection of insurance coverage
2. Selection of an insurer
3. Negotiation of terms
4. Dissemination of information concerning insurance coverage
5. Periodic review of the program
Insurance (2)
• Advantages
1. The firm can continue to operate and may experience little or no
fluctuation in earnings
2. Uncertainty is reduced, which permits the firm to lengthen its
planning horizon. No worries and fears among managers
3. Insurers can provide valuable risk management services, such as
loss-control services, exposure analysis to identify loss exposures
4. Insurance premiums are income-tax deductible as a business
expense
• Disadvantages
1. The payment of premiums is a major cost
2. Considerable time and effort must be spent in negotiating the
insurance coverage
3. The risk manager may have less incentive to follow a loss-control
program, because the insurer will pay the claim if a loss occurs
Which method?
Type of loss
Loss frequency
Loss severity
Appropriate risk
management techniques
1
Low
Low
Retention
2
High
Low
Loss control & retention
3
Low
High
Insurance
4
High
High
Avoidance
References
Rejda, George E. (2001) Principles of risk management
and insurance, Seventh edition, New York: Addison
Wesley Longman, Inc.